Friday, March 20, 2009

In last summer’s blockbuster “The Dark Knight,” the Joker invites one of the top crime lords of Gotham City to the rundown warehouse where he has stashed his ill-gotten gains. The mobster stares in awe at the huge stack of money the arch-criminal has amassed. But a moment later, his awe turns to horror as the Joker sets the money aflame.

“This town deserves a better class of criminal,” he explains.

The exchange reveals the deep evil of the Joker. Unlike a common criminal, he doesn’t just want to steal money from others. He wants to destroy their wealth.

When Americans discovered a few weeks ago that federal officials had spent another weekend of Diet Coke-fueled all-nighters concocting yet another bailout of the American International Group, they might have been reminded of this scene. This was the fourth time since September that taxpayers had rescued AIG from collapse. The new $30 billion infusion from the Treasury brought the total amount of taxpayer dollars delivered to AIG to $160 billion.

The new money was needed because AIG had suffered $60 billion worth of losses in the last four months of 2008—the biggest quarterly loss ever recorded by a single company. In fact, not many companies have even come close to being large enough to lose that much. So is AIG the most efficient wealth-destroyer the world has ever seen? Is AIG the Joker?

Fortunately not. It isn’t actually setting our money on fire. It is not destroying the fortune the government has handed it.

Unfortunately, AIG does bear more than a superficial resemblance to the Joker’s crime lord guest. It is perhaps the most efficient redistribution machine ever built. Instead of destroying taxpayer wealth, AIG has been spreading it around to a clutch of well-connected banks, domestic and foreign. As AIG’s chief executive, Ed Liddy, has explained, the company is acting as a conduit to funnel money from taxpayers to dozens of financial institutions around the world.

At the heart of AIG’s problems is a financial product called a credit default swap, which is really just an insurance contract on debt. If a borrower failed to pay off a loan fully, an investor protected by a credit default swap would be able to collect the outstanding amount from the insurance company. The idea was that credit default swaps would reduce the risk to any investor who bought bonds. In the best of worlds, they would reduce risk throughout the financial system by spreading out the costs of defaults. But that’s not how things worked out.

Instead, credit default swaps came to be used by banks in a way that no one anticipated—to avoid banking regulations. And AIG decided to get into the business of enabling this scheme.

Banks around the world operate under guidelines that determine how much capital they must hold in reserve. The rules, known as Basel II, say that the riskier the assets held by a bank, the larger the reserve they have to maintain. A U.S. Treasury bond owned by a bank does not require a reserve at all, a AAA corporate loan might only require a 20 percent reserve, and a junk-bond might require a reserve over the total value of the bond. The point is to make banks more financially secure in the event that borrowers default.

But the rules also allowed banks to reduce the riskiness of their assets by purchasing insurance on them. This created a huge demand for credit default swaps as a kind of regulatory arbitrage. The banks were able to comply with regulations while maximizing their own profits.

Say you are running a bank in Europe. You have a bunch of deposits you want to invest in assets that will give you the highest return with the lowest risk. If you buy a bunch of junk-bonds, that is counterproductive. Even if you earn more for each dollar you invest, the reserve requirements will tell you that you can’t invest as much. Now if you throw a credit default swap on, which you could buy cheaply from AIG, you can invest more of your depositors’ money. In effect, you get extra credit for the swap when calculating your reserve requirements.

AIG sold $527 billion worth of credit default swaps. That is far more money than the insurer could ever pay back. There’s no way it could make good on even a tiny fraction of them. It convinced itself, however, that only a sliver of the claims on those credit default swaps would come due. In the meantime, the company racked up fees for selling the swaps. It seemed like a money-making machine.

But isn’t it insane for banks to keep buying insurance policies from a company that obviously can’t pay them back? Bankers didn’t see it that way because they shared AIG’s expectation that few of these credit default swaps would ever come due. They didn’t expect to ever collect on the insurance policies.

So why take out insurance if you’re confident you’ll never need it? That brings us back to the regulatory arbitrage. The main reason for buying credit defaults swamps was that the regulations rewarded banks for buying them, allowing them to hold less money in reserve and invest more. Credit default swaps were more like regulatory compliance policies than insurance policies.

This wasn’t exactly top secret. AIG sold banks credit default swaps covering bonds worth hundreds of billions of dollars for precisely this regulatory reason. AIG’s annual statement revealed that about $379 billion of the $527 billion in the company’s default swap portfolio “represent[ed] derivatives written for financial institutions, principally in Europe, for the purpose of providing them with regulatory capital relief rather than risk mitigation.” That is, they were tools for getting around the rules.

Many of the banks had another reason to forget their worries about AIG’s ability to pay out on the insurance—they assumed that a complete AIG meltdown was what we call a “financial Armageddon” bet. The idea was that AIG would never be allowed to default on its obligations. American taxpayers would bail it out. And if the taxpayers couldn’t afford to bail out AIG, then the whole world would be in such dire straits that the main concerns would be food, shelter, and ammo, not the performance of a loan portfolio.

Now these banks that bought the credit default swaps are the ones on the receiving end of the AIG conduit of taxpayer money. By bailing out AIG, and therefore bailing out its counterparties, the U.S. government rewards rule bending and reckless behavior. And it is punishing responsible credit-insurance writing, essentially telling everyone who placed a premium on buying insurance from a solvent insurer that they were suckers. They should have bought the cheap contracts from AIG instead.

Perhaps most galling of all, the government has been refusing to reveal which banks have been receiving payouts funneled through AIG, claiming the insurance contracts are private business matters. Fortunately, someone at AIG seems to be leaking the names to the Wall Street Journal. The biggest U.S. recipient is Goldman Sachs. Merrill Lynch, Bank of America, Morgan Stanley, and Wachovia have also received payouts. But a far larger share is reportedly going to foreign banks, including Deutsche Bank, Société Générale, Calyon, Barclays, Rabobank, Danske, HSBC, Royal Bank of Scotland, Banco Santander, and Lloyds Banking Group. Ironically, one of the banks reported to have been on the receiving end of the taxpayer dollars passed through AIG is the Swiss bank UBS. It has been at the center of a battle with the American government over allegations that it helped wealthy clients evade U.S. taxes by hiding money in Swiss bank accounts. So the bank that helped tax dodgers is now receiving financial assistance from taxpayers.

It’s hard not to suspect that the reason Obama’s Treasury Department doesn’t want to reveal these recipients’ names is fear of a public backlash against the bailout of AIG. We were told that saving Wall Street would benefit Main Street. Instead, the bailout bucks have been going to Paris’s Champs Élysées, Frankfurt’s Bankenviertel, and London’s Square Mile.

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Aggregation of news stories and blog entries that are pertinent to the the financial stability landscape. Areas covered include risk management, structured finance, including developments in credit default swap markets.